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Diversification does not ensure a profit or protect against a loss in a declining market.

Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

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In my past post on dividend-paying stocks, some of you responded with questions about REITs (real estate investment trusts). You asked whether REITs are effective “bond substitutes,” whether they are a “defensive” equity investment, whether they’re good short-term hedges against inflation, and about their recent outperformance versus the broader stock market.

My answers are “No,” “not recently,” “no,” and “be cautious.”

With current yields on broad fixed-income portfolios less than appealing to many investors, some have argued the merits of substituting dividend-paying stocks—and REITs, in particular—for bonds. They base their argument on the fact that current bond yields are lower than the dividend yield for REITs—1.7% for the Barclays U.S. Aggregate Index versus 3.4% for the FTSE NAREIT All Equity REITs Index—and that the upside potential for stocks in any equity rally is higher than for bonds. However, as you’ll see in the chart below, REITs tend to correlate with the broader equity market, not with bonds. This is especially true in down stock markets, such as 2008-2009.

At times, REITs may outperform the broader equity market (as they have over the past several years), and vice versa. But, as the chart illustrates, if you substitute REITs for bonds in order to generate greater income, the final result is a more aggressive and more stock-heavy strategic asset allocation. In doing so, we would expect an increased likelihood of higher nominal returns over long periods of time, but that’s not necessarily because of the higher anticipated income stream. Rather, it’s because stocks are riskier and more volatile than bonds.

While I certainly sympathize with investors struggling in this low-yield environment, I just hope that we all appreciate that dividend-paying stocks, including REITs, are not substitutes for bonds. That’s not to say they won’t outperform a broad bond portfolio over the next several years. Rather, my point is that such an income-focused strategy is not a no-brainer, nor is it risk-free.

Sources: Vanguard calculations based on data from Dow Jones, MSCI, FTSE, and Barclays. U.S. stock returns represented by Dow Jones Wilshire 5000 from 1991 through April 2005 and MSCI U.S. Broad Market Index since May 2005; REITs returns represented by FTSE NAREIT All Equity REITs Index; and bond returns by Barclays U.S. Aggregate Bond Index.

REITs as an inflation hedge? It depends

Assets can be considered an “inflation hedge” if either their purchasing power is maintained over the long run or their nominal returns closely track realized inflation over shorter horizons. Assets whose returns go up with inflation are considered good inflation hedges. Treasury Inflation Protected Securities, or TIPS, are designed to be good inflation hedges. And many consider that “real” assets, such as gold and commodities, also protect a portfolio’s purchasing power because they offer the prospect of both positive expected long-run returns over inflation and a positive correlation with inflation over shorter horizons.

But what about stocks and REITs? To help answer this question, we compared the historical correlation of year-over-year CPI inflation with the returns of both TIPS and these other investments. We also compared these observed correlations with inflation with the historical volatility of the total returns on the assets themselves.

The chart below presents our results using monthly returns since 1970. The bars are sorted left to right by their average correlation to year-over-year percentage changes in actual CPI inflation. The correlation of TIPS with annual inflation is positive, indicating decent inflation-hedging characteristics (for details, see our white paper on this topic). But in this context, REITs have fared poorly, with average inflation correlation effectively zero. Investors should consider the inflation-hedging potential of REITs, like U.S. stocks in general, based on the likelihood of generating positive long-run real returns, not short-term sensitivity to inflation.

Sources: Vanguard calculations based on data from Barclays, FTSE, Dow Jones, Standard & Poor’s, and U.S. Bureau of Labor Statistics. TIPS returns are represented by Barclays U.S. Treasury Inflation Protected Index; REITs returns represented by FTSE NAREIT All Equity REITs Index; U.S. stock returns represented by Dow Jones Wilshire 5000 from 1991 through April 2005 and MSCI U.S. Broad Market Index since May 2005; commodity futures returns represented by S&P GSCI Index; gold represented by the average price for each month from Moody’s Analytics Data Buffet.

Finally, a word of caution: the first chart showed REITs rebounding nicely after March 2009. However, on a relative basis, REITs are more expensive than other segments of the stock market—U.S. stocks, as represented by the S&P 500 Index, or international stocks as represented by the MSCI World Index (for developed market equities) or the MSCI Emerging Markets Index. The figure below shows the P/Es of each index divided by the P/E of the S&P 500 Index. As of the end of October 2012, the P/E for REITs was 2.4 times that for the broader-based S&P 500 Index.

Now, I am not saying that REITS are in a bubble. But their striking outperformance versus the broad U.S. stock market has to come to an end at some point, just as other hot sectors have done in the past.

I would like to thank Karin Peterson LaBarge, Yan Zilbering, and Kyle Ashinhurst for some great assistance in this blog post.

Notes: All investments, including a portfolio’s current and future holdings, are subject to risk, including the loss of principal. Diversification does not ensure a profit or protect against a loss. Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility. Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments. While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates.

Like this:

Joe Davis

Joe Davis, Ph.D., is Vanguard's chief economist and head of Vanguard Investment Strategy Group, whose research team is responsible for helping to oversee Vanguard's investment methodologies and asset allocation strategies for both institutional and individual investors.
In addition, Joe is a member of the senior portfolio management team for Vanguard Fixed Income Group, which oversees more than $500 billion in assets under management. Joe frequently presents at various investment forums and has published studies on a variety of macroeconomic and investment topics in leading academic journals.
Joe earned his Ph.D. in macroeconomics and finance at Duke University.

Comments

Anonymous | January 12, 2013 9:39 am

What is the case for Gold and Commodities to have positive expected long-run returns over inflation? I thought they would just keep pace over the long-term, since they aren’t producing income or earnings growth.

Anonymous | January 12, 2013 12:55 am

Ok REIT may not be the place to go. I notice that Vanguard Total Stocks includes REITs and maybe that enought. I have a large amount in Total Bond Index and was wondering about the wisdom of moving a % into TIPS, both would in my IRA accout. Is this the time to do so?

Anonymous | January 11, 2013 1:57 pm

I wish I had read this yesterday. Last night I moved exchanged half my bonds for extended market and REIT funds. I knew I was shifting from bonds to equities, but I did no know REITs might be in a bubble. My bad.

My worst nightmare is that equities go into a bear market and interest rates rise to norms at the same time. That would be a killer for most “balanced” portfolios.

Anonymous | January 18, 2013 4:59 pm

Anonymous | January 11, 2013 1:37 pm

So that last chart shows that (since 1991) the P/E for REITs is sometimes close to the P/E of the S+P 500, sometimes it is higher, and sometimes it is Way Higher.
And the P/E of REITs compared to the S+P has been Way Higher for the last couple years.

Ok, that is good information to have.
I don’t really care about month-to-month changes in valuations, but that info is interesting.

My take is that when the P/E of REITs is close to the P/E of the S+P 500, then that might be a good time to add to my stake in REITs.
And that waiting for the P/E of REITs to drop below the S+P 500 P/E, and stay down for an extended period of time – probably not going to happen too often.
.

Anonymous | January 23, 2013 4:16 pm

One major reason why REITs typically trade at a higher P/E may be due to the fact that they traditionally pay higher levels of dividends along with the growth potential of the underlying real estate investments.

Anonymous | January 11, 2013 12:21 pm

One question you didn’t address: Are REIT’s a separate asset class, or are they merely another sector of stocks? In other words, if you already own Total Stocks Market to cover your US stocks, then does adding REIT increase your diversity, or does it decrease your diversity?

Also, are the wilder swings in REIT’s, relative to broader stocks, simply due to leverage?

Finally, with regard to inflation, why would we care about yearly correlation? Surely what’s important is what happens over decades. In the long term stocks have higher *nominal* returns than bonds, so they have higher *real* returns (=*nominal* returns minus inflation).

Anonymous | January 11, 2013 10:42 am

I was thinking I needed a bit more diversification and was considering adding the VG REIT fund, but seeing how relatively overpriced it is, I guess I’ll wait. Seems like I’d be buying high. Or is that timing the market?

Anonymous | January 11, 2013 9:02 pm

Depends on your time horizon. Dollar cost average into the REIT Fund. Dividens are also taxed as qualified I believe, so they will be taxed at lower tax rates vs. bond income. Better to be in the market, then time the market. If you have a long-term horizon, investing “at the top” has proved to be profitable. It would be nice to buy at the “bottom”, but nobody is that smart. We would own an island somewhere sitting on a beach. I have been buying a fized anount each month,to dollar cost average into my positions. If market tanks, I double down… It is like going to Macy’s with their 40% off coupon.

Anonymous | January 11, 2013 9:59 am

Anonymous | January 11, 2013 9:23 am

Reading “The Little Book of Common Sense Investing” by. John C. Bogle. What a great book I recommend this for all investors young and old. Intend to move all of my assets from another load fund provider shortly to Vanguard. After 25 years of investing I have become jaded by Wall Streets appetite of picking my pocket.

Given flat markets for the near future are Index funds still a good place to put my monies? I am 51 years old and am looking to buy and hold for 15-20 yrs.

Anonymous | January 15, 2013 9:20 pm

Anonymous | January 10, 2013 9:47 pm

Wow! I feel that you were talking about me. The past few months I have been investing in Vanguard Dividend ETF’s and HealthCare REITS for my IRA account. My thinking was to shelter these higher dividend paying investments and also have a change for growth.

Anonymous | January 17, 2013 3:41 pm

Definitely agree that if you own them, an IRA is the best place to hold REITS. IRAs were made for the rediculous tax treatment that REITS are subject to. My IRA is only about 20% of my portfolio but within that, about 75% are REITS. I don’t feel that 15% of my overall portfolio (.75 x .20) is too much in REITS although I have been considering trimming that exposure just a bit. If bonds weren’t such a bad investment right now I’d have the rest of my IRA in them but I just can’t bring myself to buy them at the current price/yield combination.

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Visit vanguard.com or contact your broker to obtain a Vanguard ETF or fund prospectus which contains investment objectives, risks, charges, expenses, and other information; read and consider carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss in a declining market.

Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.

All investing is subject to risk, including possible loss of principal.